REIT Compliance Through Due Diligence of Strategic Acquisitions

Understanding REITs and the Importance of Due Diligence  

Real Estate Investment Trusts (REITs) are generally either entities that own and operate real estate assets (Equity REITs) or provide financing of real estate-related assets owned by others (mortgage-REITs). REITs can be advantageous as they can typically avoid paying corporate income taxes while offering entities the ability to diversify their portfolio of real estate investments.  

As REITs look to grow their operations, one common form of expanding their investment mix is acquiring real estate-related assets. However, due to strict requirements to maintain REIT status, REIT operators must perform proper due diligence before closing an acquisition to ensure that no compliance issues will arise. 

REIT Qualification Requirements  

REIT qualification requirements of ownership, asset, and income tests must be followed to take advantage of this beneficial tax treatment. Otherwise, penalties may arise as an excise tax or, at worst, loss of REIT status. 

Due Diligence Considerations for REIT Acquisitions 

One of the first things to understand is what type of income will be generated from the acquired assets and the impact of the asset acquisition on the overall REIT tests for the portfolio. The most common way to investigate this is through a property due diligence questionnaire to review the prospective property’s leases, contracts, and financial statements and perform inquiries with the seller. 

The questionnaire includes detailed questions regarding operations at the potential property so the REIT can understand the rental structure at the prospective property (customary services or good income) as well as list out types of services provided at the property that are not considered customary and would then generally be classified as an impermissible tenant service income (bad income). Examples of these items could be, in addition to rental income generated at the property, the property owner offering dry cleaning services, weekly happy hours, or an annual holiday party, which would be considered impermissible tenant services. 

Based on the procedures listed above, management should make sure they fully understand the income generated at the property to uncover if there are any potential REIT income or asset test issues. When acquiring a loan, a mortgage REIT should make sure they fully understand the terms of the loan and whether the loan is secured by real property. When acquiring MBS securities, a mortgage REIT needs to ensure they read the Offering Circular/PPM to understand the tax ramifications of the prospective tranche. 

Understanding Business Combinations vs. Asset Acquisitions 

Once due diligence is completed and the REIT decides to proceed with the property purchase, it must determine whether, for accounting purposes, it is a business combination or an asset acquisition in accordance with Accounting Standard Codification (ASC) 805.  

As a rule of thumb, the acquisition is not a business combination if the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similarly identifiable assets. It would be accounted for as an asset acquisition. The REIT must evaluate all facts and circumstances as part of the purchase and sale agreement to account for the acquisition appropriately in accordance with ASC 805. 

Differences between an asset acquisition and a business combination include: 

Initial Measurement and Allocation 

• Asset acquisitions - acquirer measures the assets acquired based on their cost, which is generally allocated to the assets on a relative fair value basis in which no goodwill is recorded 
• Business combinations - the acquirer compares the consideration with the fair value of the identifiable assets, liabilities, and any non-controlling interests, with the difference recorded as goodwill 

Direct Acquisition-Related Costs 

• Asset acquisitions - acquirer includes all direct-acquisition related costs in the cost of the acquired assets
• Business combinations - the acquirer expenses and acquisition-related costs as incurred 

Considerations for Public Company REITs 

When a public REIT acquires real estate, the transaction may trigger financial requirements under SEC Rule 3-14 of Regulation S-X or Rule 3-05 of Regulation S-X. The acquiring REIT would need to perform required significance tests to determine the need for audited year-end and unaudited interim historical financial statements of the acquired properties or assets.  

The significance tests vary depending on whether the acquisition is defined as a real estate operation under Rule 3-14. As defined under Rule 3-14, real estate operations generate substantially all their revenue by leasing real property. 

It is important to note that generally, properties that generate revenues from operations other than leasing, such as hotels, nursing homes, or golf courses, are not real estate operations for these purposes. As such, if the Public REIT were to acquire this type of property, the financial statement requirements would be in accordance with Rule 3-05.   

There is no bright line test for determining whether a property is a real estate operation, so judgment is required. 

Significance Tests 

The significance tests are complex and full of exceptions and rules relating to the timing of acquisitions. Due to their complexity, it is highly recommended that the entity consult with both its SEC counsel and auditors to ensure that compliance will be maintained. 

The significance of an acquisition is generally measured under three separate tests – investment test, asset test, and income test. All three tests are required under Rule 3-05, while under Rule 3-14, only the investment test would apply. 

Investment Test 

An investment test is generally based on the registrants’ investments into the acquired business or real estate operations as compared to either: 

• The aggregate worldwide market value of the registrants voting and non-voting common equity or for non-traded REITs or 
• The value of the consolidated total assets as of the end of the most recently completed fiscal year for pre-IPOs. 

Asset Test 

Comparison of the entity’s share of the assets of the acquired business to the consolidated total assets of the entity. 

Income Test 

There are two different calculations that both must exceed the applicable threshold:

1. The absolute value of the entity’s equity in the pre-tax income or loss from continuing operations of the acquired business as compared to the absolute value of the pre-tax income or loss of the entities. 
2. The entity’s proportionate share of revenue from continuing operations of the acquired business as compared to the entity’s total revenue. 

The Public REIT needs to discuss its need for the acquiree's financial statements with the seller as part of the due diligence process to ensure that the financial statements necessary can be provided on a timely basis.     

By following these due diligence best practices, REITs can confidently expand their portfolios while maintaining compliance with regulations and safeguarding their advantageous tax treatment.